‘Total Return’ Needs to Consider Tax, Inflation

In its 2013 tax guide and in a recently released viewpoint, “Get Real: Focus on Real After-Tax Returns,” Fidelity helps retirees understand why they may want to adopt a strategy focused on actual after-tax returns, and not just total return.

Investors focused solely on what the market is doing for their portfolios are only seeing half the picture, according to John Sweeney, executive vice president at Fidelity. “It’s the returns they can generate after inflation and taxes that tell the whole story,” Sweeney said. “Fidelity is encouraging investors to sharpen their focus on real after-tax returns, which is what remains after taxes and inflation are accounted for, and not just on nominal pre-tax returns—also referred to as total returns.”

A recent Fidelity investor poll shows 63% of investors are concerned about taxes. Taxes and inflation can both eat into the buying power of an investor’s portfolio, the firm cautions, which puts retirees living off their investments at particular risk.

At worst, rising inflation and taxes may force retirees to increase withdrawals to maintain their lifestyle, which could mean they run out of money prematurely in retirement, need to cut back their lifestyle, consider returning to work, or some combination of these outcomes.

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Options for Tax-Efficient Investing

Tax rates are going up for some high-income earners. For others, the biggest change may be a new level of certainty around the tax code. “Now that many of the expiring tax cuts and temporary tax relief provisions have been made permanent, investors have the opportunity to take stock of the situation, create a careful plan, and then put it into practice over the coming years,” Sweeney notes.

While taxes have been top-of-mind for many investors, decades of moderate inflation may have made many complacent about risk that it can pose to their portfolios. History contains several examples of time periods when both inflation and tax rates were on the rise, and the challenge that dynamic can pose for investors.

Two potential strategies designed to help alleviate these concerns include the use of “real return” investments that aim to outpace inflation, and Roth retirement savings accounts, which are funded with after-tax money but offer tax-free earnings, provided certain conditions are met.

Making the Case for Inflation-Sensitive Investing

In “Get Real: Focus on Real After-Tax Returns,” Fidelity illustrates the impact inflation and taxes have had on portfolio returns when both rose together, and the challenge it can pose for retirement planning. The historic analysis shows why investors who think inflation may be rising may want to consider an allocation to “real return” assets—including Treasury inflation-protected securities (TIPS), leveraged loans, commodities and real estate—instead of a traditional stock and bond portfolio.

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It also shows the benefits of a Roth account to help manage the risk of rising tax rates and the impact of using both real return assets and Roth accounts together. 

Many investors have several types of accounts. Some are subject to normal tax rules, and others have tax advantages. Limits on contributions and withdrawals prevent investors from simply saving everything in tax-advantaged accounts.  

“Get Real” also offers tips to help decide what assets to put into which vehicles. If any of the following four criteria apply, then an investor should review their portfolio for tax-efficiency: 

• Paying a high tax rate;
• Expectation of lower income tax rates in retirement;  
• Tax-inefficient investments currently held in taxable accounts; and
• Investment time horizon of 10 years or more.

“It’s important not to let the tax tail wag the investment dog,” Sweeney said. “Establishing an appropriate asset allocation is the foundation of a sound investment strategy, and should remain an investor’s first priority. The potential impact of taxes should be secondary, but an important second.”

Fidelity also released a companion piece, the “Taxpayer’s Guide to 2013,” which details the 2013 tax changes, including two new taxes that were not repealed as part of the fiscal cliff deal: the Medicare payroll tax and Medicare surtax on net investment income.  

Included is a chart comparing tax rates for 2013 vs. 2012 for all income ranges for the following:

• Ordinary income and short-term capital gains;
• Long-term capital gains;
• Dividends;
• Estates and gifts;
• Unearned income (Medicare contribution); and
• Medicare payroll tax.

“The Taxpayer’s Guide to 2013” and “Get Real: Focus on Real After-Tax Returns” are both available online.